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Financial Management and Analysis of Projects :
6. Financial Institutions
6.3. FI Investments
6.3.1. Introduction
6.3.1.1. This section describes ADB's approach to FI investments. It discusses
selection of participating institutions and appraisal approaches.
6.3.2. Investing in FIs
6.3.2.1.
ADB's involvement in a country's financial sector is
set out in the CSP and driven by ADB's overarching poverty-reduction
objective. As relevant, the CSP: (i) shows how the financial sector
affects country development prospects; (ii) highlights reforms to
be supported by ADB financial sector operations, including their
sequencing; and (iii) states why the proposed operation is the appropriate
vehicle for ADB support for reforms.
6.3.2.2. As appropriate, ADB consults
with the IMF, the World Bank, and selected donors on proposed FI
lending, and it coordinates its financial sector strategies and
operations with theirs.
6.3.2.3. One of the forms of ADB's
intervention in the financial sector is an FIL. Under an FIL or
an FIL component of an investment loan, ADB provides funds to eligible
participating FIs for onlending, at the FI's risk, to final
borrowers.
6.3.2.4. The appraisal should ensure
that the following objectives of FI lending include: (i) supporting
reform programs in the financial sector or related real sectors;
(ii) financing real sector investment needs; (iii) promoting private
sector development; (iv) helping to stabilize, broaden, and increase
the efficiency of financial markets and their allocation of resources
and services; (v) promoting the development of the participating
FIs; and (vi) supporting the country's poverty reduction objectives.
6.3.2.5. FILs are provided in the
context of sound analytical work on sector issues, appropriate technical
assistance, and, as relevant, adjustment operations to address policy
issues.
6.3.2.6. ADB's intervention
in the financial sector may also be in the form of other lending
instruments (e.g., structural and sector adjustment loans and technical
assistance loans), guarantees, and nonlending activities (e.g.,
country economic and sector work, training, and financial advisory
services).
6.3.3. Selecting Participating Institutions
6.3.3.1.
ADB's Economics and Research Department (ERD) developed a
paper in 1999 that explored in detail approaches to selecting participating
financial institutions in credit projects. This paper, Towards
Good Practice, can be accessed in the Knowledge Management
section of the web-based Guidelines.
6.3.4. Appraising an FI Investment
6.3.4.1. Introduction
6.3.4.1.1.
ADB's appraisal of an FIL should:
- confirm,
with justifications, if it is the appropriate intervention to
achieve the desired objectives with due regard to the sustainability
of the financial sector;
- establish
the financial and economic justifications for the operation;
- confirm,
for an FIL justified by its poverty-reduction goals, that it is
a practicable, cost-effective way of achieving such goals;
- confirm
the eligibility of FIs proposed for inclusion; and
- confirm
that implementing the FIL is not likely to undermine the financial
condition of participating FIs.
6.3.4.1.2.
The economic analysis of an FIL should take into account the prevailing
and expected macroeconomic environment and substantiate that the
proposed operation will lead to net economic benefits arising from
policy and institutional changes and increased availability of investment
funds.
6.3.4.1.3. If the justification for
an FIL depends critically on addressing perceived market failures
(i.e., nonmarket effects or externalities), the analysis should
explain the assumptions and their empirical basis. If there is evidence
of a subsidy involved in an FIL such that resources, through interest
rates or other forms, are provided below their economic opportunity
cost, the extent of subsidy dependence must be calculated and assessed.
6.3.4.1.4. Risk analysis should be
used to demonstrate how robust the projected economic benefits of
the project are to possible changes in assumptions about the macroeconomy,
borrower commitment to the reforms supported by the FIL, and institutional
performance. Note that this reference to risk analysis should not
be confused with market risk and associated indicators.
6.3.4.2. Sub-Projects
6.3.4.2.1.
Increased production of goods and services should be established
at the subproject level. It must be derived from expanding existing
productive capacity, increasing the efficiency of capacity utilization,
or creating new types of productive capacity. Working capital financing
to maintain existing levels of production is not eligible for ADB
financing.
6.3.4.2.2. FILs are used to finance
investments in subprojects for increased production of goods and
services. The subprojects must meet eligibility and development
criteria agreed with ADB. ADB agrees with the borrower on appropriate
arrangements to monitor subproject compliance with these criteria.
In addition to the above criteria, the appraisal should ensure that
subprojects are financially viable and technically, commercially,
managerially, and environmentally sound.
6.3.4.3. Use of ADB Funds
6.3.4.3.1.
The borrower may pass on ADB funds to a FI either as a loan or as
borrower's equity; similarly, FIs may pass on ADB funds to
subborrowers as subloans or equity investments. In all cases, ADB
funds are disbursed against eligible expenditures for goods, works,
and services.
6.3.4.3.2. FILs are normally amortized
by ADB's borrowers on country terms as established by ADB and not
on a back-to-back basis (by earmarking subborrowers' repayments
for amortizing the ADB loan). The borrower may pass the funds on
to FIs either on a back-to-back basis or on the basis of another
amortization schedule acceptable to ADB.
6.3.4.3.3. When FI loan repayments
to the borrower are not on a back-to-back basis, FIs may, within
their overall loan amortization schedules, use repayments for purposes
that are consistent with their business strategies, or for prepayments
to the borrower. Under an apex or two-tier lending arrangement,
ADB funds are passed initially to an apex (first-tier) institution,
which onlends them to the participating retail financial institutions.
6.3.4.3.4. An FI with actual or potential
conflict of interest cannot serve as an apex institution.
6.3.4.3.5. Two-tier lending arrangements
are common, but a three-tier arrangement may be feasible, particularly
to address micro-credit operations.
6.3.4.4. Onlending Terms
6.3.4.4.1.
FIL onlending terms are set in the
context of a borrowing country's interest rate structure and any
agreed program for interest rate reforms.
6.3.4.4.2. ADB funds are priced to
be competitive with what the participating FIs and their subborrowers
would pay in the market for similar money, taking into account,
as relevant, maturities, risks, and scarcity of capital.
6.3.4.4.3. When interest rates are
not market-determined and there is an agreed program of interest
rate reforms, FIL funds are onlent to participating FIs at interest
rates agreed with ADB that: (i) are not negative in real terms;
(ii) provide adequate margins to FIs to cover all costs, including
credit and other risks, and an adequate profit margin; and (iii)
do not discourage resource mobilization from the market by providing
a price advantage in using FIL funds.
6.3.4.4.4. ADB funds may be onlent
to participating FIs and their subborrowers in either foreign exchange
or domestic currency on the basis of prudent credit decisions, including
prospective subborrowers' ability to bear the foreign exchange
risk to avoid later credit risk. Where interest rates are market-determined
and there is relatively easy capital movement, local currency interest
rates include an implicit premium that reflects market expectations
in regard to exchange rate changes. In such situations: (i) ADB
FIL funds are onlent to FIs in either local or foreign currency,
provided the on lending interest rates are consistent with prevailing
interest rates in the borrowing country for comparable credit; and
(ii) FIs normally onlend to subborrowers in the same currency or
currencies that the FIs borrowed.
6.3.4.4.5. If interest rates are not
market-determined but are set administratively, it is not possible
to determine market expectations of exchange rate changes, as foreign
exchange risks may be under priced in local currency interest rates.
Therefore, the foreign exchange risk of FIL funds is borne either
by: (i) subborrowers through borrowing and repayment in foreign
currency, or (ii) the government if onlending and repayment are
in domestic currency at prevailing administered interest rates.
In the latter case, the government charges a fee that is passed
on to FIs and subborrowers to offset the anticipated foreign exchange
risk.
6.3.4.5. Monitoring Financial Institutions Investments
6.3.4.5.1.
During project appraisal and negotiations,
provision is made for effective monitoring and evaluation of the
FIL's progress toward its objectives and development impact throughout
the life of the project.
6.3.4.5.2. The performance indicators agreed
on at loan negotiations cover sectoral, financial, and institutional
variables.
6.3.4.5.3. The variables for the FIs
include among other things, adequacy of capital, quantity and quality
of earnings, quality of assets, sufficiency of liquidity, extent
of subsidy dependence, effectiveness of FI loan administration (appraisal,
supervision, and collection performance), and adequacy and timeliness
of preparation of audited financial statements. During implementation,
ADB, the borrower, and the FIs in each tier must use the agreed
performance indicators, implementation progress reports, and a review
of a sample of subprojects to monitor the FIL's progress.
6.3.4.5.4. At least once each year
during implementation, ADB conducts a formal review of the condition
and performance of participating FIs, including a review of their
audited financial statements, to determine their continued compliance
with eligibility criteria. The findings of this review are to be
recorded in supervision reports.
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6.4. Assessing FI Performance |
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